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Finding Value in HMOs

The part I hate about writing is the first paragraph 
the introduction. You have to say something pithy that grabs
readers attention and sets the tone. Sometimes the intro
comes naturally; most of the time it doesnt. I wanted to
write an article about health maintenance organizations, but
after staring at the computer screen for a few hours I still
didnt have an intro. I was about to give up when it
occurred to me to stick to my contrarian roots and write an
article without one.

So here goes.

HMOs appear to be perfect stocks for todays market.
They have good balance sheets, terrific free cash flows and
recurring, highly economics-insensitive revenues. The global
macro stuff doesnt really affect them. Greece could be
abducted by aliens, Spain could go to war with Finland, and
wed all still be getting sick and buying health
insurance. Rising unemployment and underemployment might put a
small hole in my rosy thesis, but no worries: With 10,000 baby
boomers signing up for Medicare every day and expected to do so
for the next decade, that hole will patch easily.

What intrigues me the most about these companies is that
they are misunderstood by investors. Though we call them health
insurers, they are not really insurance companies, at least not
in the true sense of the term. Yes, they take premiums up front
and pay out medical costs over time, but they are actually
health care logistics companies  they pass on health care
costs to their customers. They are only insurance companies if
an investors time horizon is a few quarters, because once
in a while theyll misprice the risk and their
profitability will stutter. However, since they reprice their
business every 12 months, the mispricing will be fixed at the
next renewal. Even in their worst years, HMOs still make a lot
of money.

During the 1990s, HMOs tried very hard to manage rising
costs, even as their reputation was undermined (in John
Grishams 1995 bestseller The Rainmaker, an insurance
company played the villain). Since then the industry has gone
through a transformational consolidation that has helped it to
achieve significant economies of scale and more-rational (less
competitive) pricing. HMOs stopped fighting rising health care
costs and embraced them; they just pass them on, dollar for
dollar, to the customer. In fact, they woke up to this little
realization: Health care inflation is their friend ­
it drives revenues and thus profitability.

It is also assumed that there is a constant political risk
with HMOs. True, politicians love to hate HMOs, especially in
their speeches and presidential debates. You pick up a lot more
voters when you go after evil HMOs than when you
embrace them as the most cost-effective alternative. Despite
all the negative rhetoric being spit out by spineless
politicians, HMOs are not going anywhere. They are deeply
integrated into our health care system  they are our
health care system.

And here is the most ironic part: Even if political rhetoric
in the pursuit of cost savings spilled over into fierce action,
and HMOs were euthanized and their profits were nationalized,
the U.S. would save only about $13 billion a year (the total
profitability of the HMO industry). Though it sounds like a
fair chunk of change, thats only 0.6 percent of our total
$2.2 trillion in health care costs, or a few months of
health care inflation. And to provide logistical health care
services, the government would have to make a sizable
investment (probably over $100 billion) and take over
administration of health care. The $13 billion that HMOs
currently earn would look like a promised land that the
government would never reach.

Lets face it, government is good at doing some things,
like running courts and the military. But due to misaligned
incentives and inherent bureaucracy, government will never be
as efficient as for-profit enterprises. This is why the U.S.
prospered and the Soviet Union disintegrated.

In the first two years of the Obama presidency, HMOs faced
uncertainty as to whether Obamacare would even let them
survive. Now that the impact of Obamacare on HMOs is for the
most part known and uncertainty has turned into certainty, the
companies will enjoy an influx of customers, courtesy of the
U.S. taxpayer, but with them will come lower margins. Net-net,
Obamacare should not have a significant impact on their
business. But HMOs are priced as if the Obamacare outcome were
still uncertain  they sport single-digit price-earnings
ratios on earnings that are continuing to rise and that have
grown into the mid-teens over the past decade.

Since I started this article without an introduction,
Ill finish without a conclusion  or at least
without recommending any specific companies, as the entire HMO
industry looks attractive.

Vitaliy Katsenelson (vk@imausa.com) is
CIO at Investment ­Management Associates in Denver and
author of The Little Book of Sideways
Markets.